In the third and final part of this series on investing for your children, we look at an indirect investment option through insurance bonds – a tax paid investment that is arguably well suited for this purpose. Issued by life insurance companies, ‘insurance bonds’ are also marketed as ‘investment bonds’ or ‘investment growth bonds’.
What is an insurance/investment bond?
Insurance bonds are long-term investment vehicles that offer tax efficiency for some investors. While technically incorporating a life insurance element, they are tax-paid investments that focus on wealth creation by investing in a single asset (e.g. ‘Australian shares’) or multiple asset classes (e.g. ‘balanced’).
Insurance bonds are designed to be held for at least 10 years. The issuer of the bond pays tax on the earnings of the underlying investments at the corporate tax rate of 30%, which, under a special tax rule, means that the investor does not need to include any investment earnings in his or her tax return. After 10 years, the investor can redeem the insurance bond and won’t be liable for any capital gains tax.
If the investor chooses to redeem the insurance bond before 10 years, he or she is required to pay tax on the earnings of the bond at their marginal tax rate, less a tax offset of 30% to reflect the tax the issuer has already paid. If the bond is redeemed during the ninth or tenth year, transitional provisions apply.
One additional rule (known as the ‘125%’ rule) makes them more attractive as savings vehicles. Under this rule, investors can make additional contributions up to 12% of the previous year’s contribution, with the benefit of these contributions being treated as if they were invested at the same time as the original investment. For example, if you invested $1,000 to start an insurance bond, you could invest a further $1,250 in year two and a further $1,562.50 in year three and have, for tax purposes, the same 10-year term expiry being the tenth anniversary of the original $1,000.
How do they work for kids or grandchildren?
If the child is 10 years or over, then with parental consent, the investment can be made directly in the child’s name. The minimum investment for some insurance bonds is as little as $500.
Most insurance bonds also include a ‘child advancement policy’. Under this feature, the investment is initially made in your name and at a certain nominated time (known as the ‘vesting age’), the bond is automatically transferred to the child. Vesting does not trigger any tax consequences, and there are usually no fees or charges. The child must initially be under 16 at the time the policy is taken out, and the vesting age can be any age from 10 years to 25 years.
Who issues them?
Insurance bonds are issued by Australian Prudential Regulation Authority (APRA) regulated life insurance companies. Three of the major issuers and details of their bonds are detailed below:
Pros and cons
As they are tax paid investments, and you can invest in relatively small starting amounts, they are pretty attractive vehicles for investing for your kids or grandchildren. There are no issues with the minor’s ‘unearned income’ tax and in many cases, the tax paid rate of 30% on an insurance bond, is going to be more tax effective than the minor’s tax rate of 45%.
The 10-year investment time frame (minimum) will probably not be an issue for most parents or grandparents considering this alternative. The two downsides are the insurer’s management fee (these range from 1.0% per annum to 1.5% per annum), and unlike direct shares, an indirect investment like an insurance bond may not be as effective in helping to cultivate and develop an interest by your child or grandchild in investing.
Bottom line
If selecting an insurance bond, look at a ‘growth’ oriented option, such as ‘Australian shares’ or ‘growth’ – 10 years is a long time. Management fees matter – and as it is impossible to predict who is going to be the best performing manager over this period, apart from any other considerations such as the minimum investment size, go for the issuer with the lowest fee.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
